Every investor has their own process of finding potential buys for their portfolios. I used to scour through 100s of charts a week looking for potential stock picks. On the contrary, some independent investors will scan through 100s of balance sheets a week looking for trade ideas. But, which is a better place to start your market research, Technical or Fundamental Analysis?
Before comparing the two, it is important to understand the difference between both technical and fundamental analysis. I covered and compared both technical analysis and fundamental analysis before on this blog, and the summary is really this:
- Technical analysis uses charts (read my post on how to read a stock chart) and graphs to determine what investments are good. Technical indicators such as volume and relative strength are used daily. These types of investors believe that historical performance in individual stocks and the overall market will determine what happens tomorrow.
- Fundamental analysis uses the economy and key facts about the company itself to determine the soundness of an investment. Instead of looking at charts, taken into consideration are factors such as company debt, product lineup, sales growth, and earnings. These investors in the end want to place stocks into categories such as "sell," "buy," and "hold".
Technical Analysis First, Then Fundamental
The advantage of conducting technical analysis as a form of market research before fundamental analysis is that you can quickly find stocks that are poised and ready to break out or move to the upside. Not always but typically any stock that has setup in a nice base and looks promising already has decent to strong fundamentals established.
Another big advantage of technical over fundamental analysis first is that technical patterns are a lot more easier to find than scanning through balance sheets and income statements on specific companies. If you use a paid stock charting software such as Daily Graphs Online, you can simply pull up a pre-made list and go through a chart virtually every second or two.
Advantages of conducting technical before fundamental analysis:
- Technical analysis is a lot faster. You can Scroll through 100s of charts in the amount of time it can take you to analyze a handful of balance sheets and income statements.
- Depending on the pattern, but for instance cup and handle patterns that are setup correctly are usually formed in fundamentally sound companies. Find the pattern setup correctly and the fundamental research may already be done for you.
- You can rely solely on technical analysis to make investment decisions. Especially when it comes to day trading, it doesn't matter how much cash flow the company did in Q3 of last year, you are looking to get in and out as quickly as possibly.
After you have narrowed down a few hundred charts to some setups you like and find attractive, then go through and check out the company fundamentals to narrow your search even more. A William O'Neil stock tip is to never hold more than a few stocks in your portfolio at a given time. So, narrow down your technical search to say 20 stocks, then explore their fundamentals, then go back to technicals again and see if you can't find a winner.
What really isn't tied in here is the factor of time and what you are looking for heading into the research. If you are looking for a short term hold, say less than a month then technical analysis may very well be the quickest way to find a play. On the flip side though, a sound company expecting a great earnings report can be a great short term play :twisted:.
Fundamental Analysis First, Then Technical
The big argument for fundamental analysis over technical analysis is simply the mentality that, "hey, if the company is great in the books, it will go up over time regardless of what a stock chart says right now." And, this has a lot of truth in it, especially for longer term holds. A sound company say Apple or Exxon will always have a much stronger shot at going up over the long term than a company leaking billions of dollars every year, GM for example.
The advantages of conducting fundamental analysis before technical analysis:
- It may take longer, but once you find a great company financially, the mentality that strong companies always perform well in the long run may very well hold true. You don't care if its Relative Strength Index (RSI) is showing overbought, you buy anyway.
- A good fundamental research session will narrow down the playing field a lot more deeply then a standard stock chart scan. You walk into conducting your chart analysis knowing that every pick you have is strong already, so really technical analysis is just a simple way to narrow down an already elite group of stocks.
Great investors like Warren Buffet rely almost solely on fundamental analysis to make their stock picks. The only tie they have to technicals is with the stock price which is just used to determine is the company is cheap based on its earnings per share, book to value ratio, etc.
The biggest argument against conducting fundamental analysis first would probably be the time aspect. Some traders make their living on the fly and don't want to spend the extra time to go through every company. They narrow down their search based on what they see and like, and simply use fundamental analysis to help put one stock in the better buy position. As soon as you bring in the long term (time) aspect in though fundamental analysis holds a big upper hand.
A Matter of Personal Preference
In the end it may just be a matter of personal preference as to which you like or are better at. I personally am much more advanced at integrating technical analysis, and as a result I almost always conduct it first before looking at a company's fundamentals. On the flip side someone who has been trained on comparing earnings per share, debt, and cash flow would much rather take a look at those factors before anything else.
Another important factor is the type of trader you are. Swing traders and momentum traders differentiate themselves from say a long term value holder. Day trading is purely technical analysis as speed is everything and predicting price swings over blowout quarters is the sole key to success.
Larger investment houses almost all rely solely on fundamentals to make their decisions, and can't even attempt to tie in technicals before taking a big position. When you are buying a billion dollars worth of stock you are looking at up to a month if not longer to take your full position. And, as soon as you get in, you aren't going to look to get out anytime in the near future. There simply cannot be a choice; it has to be fundamental analysis first, last, and everything in between.
In the end every investor has their own personal preference as to which they prefer. Someone in love with volume trends and volatility is going to browse through a few hundred stock charts before pulling out the balance sheets. And, the value investor who is constantly on the prowl for new and undiscovered products and trends to emerge will always be more involved on the fundamental side before the technicals kick in. So the real question then is, which do you prefer first and why?